While the “real” economy has been tumbling for the past two years or so, social applications, online gaming, and the virtual economy have proven to be fairly resilient[2] in the face of the economic slump. Some reasons for this resilience could be that people have more free time, and that they generally don’t mind making small payments on virtual goods. The worldwide virtual goods market (which is a subset of the virtual economy) is estimated to be around $5 billion, with 80% coming from Asia (China, South Korea, and Japan) and only $200 million to 400 million from the US. Several players have emerged to take advantage of this opportunity. Third-party developers on Facebook are projected to make $500 million[3] this year, and while most end users think of social applications (and games) as the only players in the space, there are several others. In this article, I will touch on only one missing piece of the puzzle: the virtual economy. Next week, I will cover some other players which together with social apps[4] and online gaming[5] make up the social media and online gaming ecosystem[6].

Social apps, MMOGs (massive multiplayer online games such as eRepublik), mobile apps and online gaming generally have four sources of revenue: i) paid games or apps (this model is especially popular on the iPhone), ii) in-app ads, iii) virtual goods (usually in games and not in other apps), and (iv) referrals (for example, LivingSocial gets referrals fee from Amazon). There are hardly any paid apps on Facebook. By some estimates, virtual payments are proving to be a much bigger source of revenue than in-game ads. Virtual goods and payments play an important role in the monetization of social games. Players are enticed to buy points to move to a new level of the game or to make small purchases (virtual goods). Users send each other virtual gifts. Other ways of making money are making advertising offers (we will cover advertising next week). Offerpal specializes in such offers — an example of an advertising offer is asking a user to sign up for (or upgrade) a Netflix account in exchange for virtual coins that can then be spent on virtual goods.

You might ask why virtual goods can’t be purchased using “real” currency. There are at least three reasons: i) micro transactions are too small (let’s say 5 cents) to justify transaction charges; ii) it’s convenient to be able to pay while playing; and iii) virtual currencies and alternative payments provide a nice abstraction over the myriad forms of payment systems worldwide.

The virtual economic ecosystem is complicated and rapidly evolving. Based on my interviews and research, I place different companies in different layers, but these layers are loosely defined and many of the companies I discuss would claim to be either in another layer or to encompass more than one layer. I welcome thoughts from the respective companies, but as I said, the placement is by no means definitive and is simply supposed to illustrate the ecosystem in general. Also, there are several companies that I do not mention, and the ones I mention are not necessarily leaders in their space.

Notes:

1) Not all layers are involved in a particular transaction. For example, a social game might skip layers 3 and 4, and directly use virtual currency and payment aggregators to enable users to upgrade to a new level.

At the bottom of the stack are the traditional payment companies such as Paypal, credit cards, and banks. However, there are also alternative payment companies, which have become popular recently. In many countries where there are few consumers with credit cards, these alternative payments become essential. BOKU[7], one such company, doesn’t require users to have a credit card or bank account and allows them to charge payments on their cell phone bill in about 50 countries. The cell carriers charge exorbitant fees (30-50% in the US!), but this form of payment increases the reach of developers to consumers who don’t have another choice of payment. It also makes sense for virtual goods, which have near zero cost of goods sold. Playfish[8] allows players to buy coins using credit cards, Paypal, BOKU, TrialPay[9], and PayByCash[10]. It’s clear that developers would like their consumers to use payment methods that are cheaper, and having a mobile payment option (high transaction fee) can actually cannibalize their sales; however, BOKU’s value proposition is to reach consumers who otherwise could not have paid. BOKU also claims that adding a mobile payment option doesn’t cannibalize other forms of payment.

Virtual Currencies and Payment Aggregators

Next in the stack are the companies that either provide their own virtual currencies (MMOGs such as Linden Lab, eRepublik and social networks such as Hi5 and Facebook, Zeevex, SparkCash); power technology behind other currencies (Viximo[11], Jambool[12]); aggregate different forms of payments including credit cards, mobile payments, Paypal etc. (PlaySpan[13], which owns PayByCash and Spare Change); or let users buy virtual coins or goods by signing up for offers (Netflix) or filling out surveys (SuperRewards, Gambit, Offerpal, Trialpay, AdParlor, Peanut Labs, Sometrics, and Gambit). They all usually handle customer support, foreign exchange, and fraud.

It’s also important to note that many of these companies such as Viximo and Jambool also play in the infrastructure and analytics layer. It can also be argued that BOKU and Zong exist in this layer, although I think that they are best described as “direct” payment systems and not payment aggregators.

Infrastructure and Analytics

Usually many players in layer 2 offer analytics, but Twofish[14] claims to specialize in and dominate this space. Twofish provides backend analytics and “inventory management” of virtual payments and can integrate with several virtual currencies. Twofish captures transactional graphs by recording the credit and debit history for every transaction that happens in a game. Its analytics tool records enormous amounts of data and helps mine and visualize it. In a nutshell, Twofish is the analytical engine that runs behind virtual economies. From an end user perspective, consumers have no knowledge of players in this layer.

Virtual Goods

This is the layer (along with publishers) that most users see the most often. Several players provide technology and content to power virtual gifts. Viximo is one of the dominant players in this space. Facebook also sells virtual gifts and is said to make around $50 million a year from them.

Publishers

At the top of the stack are the game developers who develop games (social, MMOGs, online) or applications that use virtual goods. It’s important to note that in some cases, layer 4 (virtual goods) would be the top layer — for example, in a virtual gifts application.

While there will be disagreement on where each company plays (for example, Viximo claims to play in layers 2, 3, and 4), it is clear that the virtual economy is nascent and that we will see a great deal of consolidation in the next few months and years. Much of this consolidation will happen within each layer, but it will also occur across layers. BOKU has already bought Paymo and MobillCash, and PlaySpan bought PayByCash and Spare Change. Giants such as Amazon, Apple, and Paypal are vying to offer universal currencies. The Chinese government felt so threatened by the virtual economy that it imposed regulations to separate virtual currency from the real economy[15]. Eve Online[16], an MMOG, hired a real-life economist to manage its virtual economy. There is plenty of growth expected in markets outside Asia (especially in Europe, North America, and South America) where the virtual world hasn’t caught up so far. It’s not a stretch to say that there will probably be virtual currency exchanges, funds, and markets and therefore regulations on virtual payments in future, but the complexity and challenges undoubtedly present several opportunities for entrepreneurs.

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About Me

I am an e-Money researcher and a Founding Director of the Bitcoin Foundation. My career has included senior influential posts at Sumitomo Bank, VISA, VeriSign, and Hushmail.

"Free-market protagonists, such as Matonis, regard cybercash as better than traditional government-issued or -regulated money, because it is determined by market forces and thus nonpolitical in nature." --Robert Guttmann, Professor of Economics at Hofstra University, in Cybercash: The Coming Era of Electronic Money, 2002

"Matonis is quite correct that the new technology makes easier the use of multiple private currencies." --Mark Bernkopf, Federal Reserve Bank of New York, in "Electronic Cash and Monetary Policy", 1996

"Matonis argues that what is about to happen in the world of money is nothing less than the birth of a new Knowledge Age industry: the development, issuance, and management of private currencies." --Seth Godin in Presenting Digital Cash, 1995